Evaluating hybrid annuity target-date strategies

Hybrid annuity TDFs combine the asset accumulation offered by TDFs with an annuity that provides guaranteed lifetime income.¹

For a hybrid annuity TDF, the allocation to the multiasset portfolio decreases while the allocation to the income-funding product increases along the life-cycle glide path. Some or all of the assets invested in the income-funding allocation can be used to buy an annuity in the future. The balance of the portfolio remains invested in the income-funding product and the multiasset portfolio (traditional TDF), which derisks as the investor approaches retirement. 

While the income-funding investment is liquid, structure and approach vary among hybrid annuity TDF providers. For example, one annuity-funding strategy entails aligning assets to expected annuity cash flows and pricing. This process can have contrary implications for investment returns and annuity pricing. The downside to prefunding is lower return potential, but the benefit is lower annuity pricing risk.

A related consideration regarding annuity prefunding is the optionality feature for the annuity contract. Of the few providers offering hybrid annuity TDFs, most do include an option at retirement for participants to remain invested in the multiasset target-date strategy or enter the annuity contract. This optionality provides flexibility but also entails the risk of missed growth opportunity if a participant opts out of the annuity purchase. 

While an investment case for hybrid annuity TDFs can be made for some participants, the implementation, structural, and suitability hurdles are high. This is because the decision to purchase an annuity is a multifactor, highly personal one that includes:

• How long does the participant expect to live given current health and family history?
  
  
• How much of the participant’s accumulated wealth should be annuitized?
  
  
• What is the best time for the participant to purchase an annuity?
  
  
• Which annuity is the best choice?
  
  
• Is the peace of mind that an annuity might bring worth the annuity’s cost?
  
  
• Is the participant comfortable exchanging liquid assets for an illiquid contract with an indefinite payoff?

With so many questions, annuity solutions typically require a personalized approach. However, as a qualified default investment (QDIA), TDFs are a one-size-fits-all solution. To fully unlock the benefits of an annuity, participants need to actively make decisions, embrace the additional complexity of the solution, and be comfortable with the additional costs involved in the process. If participants can do that, there can be benefits to a hybrid annuity TDF. But they should be weighed against the risks. 

• Potential improvement in investor satisfaction.
  
  
• Mitigation of longevity risk.
  
  
• Peace of mind for investors worried about outliving their retirement assets.
  
  
• Possible improvement in investor outcomes.
  
  
• Simplification of decisions regarding annuity type, timing, and allocation.
  
  
• Institutional annuity pricing.

• Inability to transfer the annuity benefit.
  
  
• Suitability risk, stemming from one product potentially being suboptimal for most.
  
  
• Difficulty integrating the user experience, resulting in a disjointed user experience.
  
  
• The need for a higher level of investor engagement.
  
  
• Behavioral hurdles in exchanging liquid for illiquid assets.
  
  
• Opportunity costs from prefunding an annuity allocation with cash-like returns.
  
  
• Increased educational requirements.
  
  
• Lack of transparency, as annuity prefunding and purchase process is opaque.
  
  
• Lack of investor demand.
  
  
• Complexity of annuities.
  
  
• Increased fiduciary risk for plan sponsor.
  
  
• Higher costs relative to existing off-the-shelf TDFs. 

 

We are continuing to evaluate the investment merits of hybrid annuity TDFs as part of our ongoing TDF glide path due diligence and expect to publish detailed research findings later this year. In the meantime, our approach to retirement income is to help retirees manage and spend what they’ve worked hard to save with a combination of investment strategies, spending services, guidance and advice, and access to out-of-plan annuities for all participants in plans record-kept at Vanguard.

Notes:

• All investing is subject to risk, including the possible loss of the money you invest.
• Investments in target-date funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in target-date funds is not guaranteed at any time, including on or after the target date.